Note: The paperback edition of Flash Boys was released this week. This review is of the hardcover edition.
Flash Boys - Michael Lewis
The most remarkable thing about Michael Lewis’s tale of the rise of High-Frequency Trading (HFT) and the ‘fracking’ of the equity markets detailed in Flash Boys is not that it happened – after all, massive amounts of brain power are directed at financial markets to search for and exploit any available loophole – rather, the astounding realization you walk away with is that it happened under the noses of trained professionals who had just as much incentive to see that they were not being taken advantage of.
Anyone who has been licensed to sell or advise on securities has been tested on how markets function – the types of orders, the regulations surrounding disclosure of bids & offers, which orders take precedence, etc. – but, as Lewis explains, as far back as 2007, the world as traders knew it no longer functioned in a way they understood.
“The U.S. stock market now trades inside black boxes, in heavily guarded buildings in New Jersey and Chicago.” - Michael Lewis
The three historical exchanges, the New York, the American, and NASDAQ, and their trading floors in the case of the first two, had been joined (and in the case of the American, replaced) by rival exchanges and ‘dark pools’ – brokerage-owned proprietary exchanges – where computers replaced specialists and speed became king. From a world where a stock was listed on one of the traditional exchanges exclusively, shares could now trade on any of over three dozen platforms. And where there are multiple markets, there is opportunity for arbitrage – the simultaneous trading of the same stock at different prices.
As Lewis fascinatingly details, the High-Frequency Traders went a step further and induced markets to rig the game to create risk-free arbitrage through trading algorithms, co-location of computing power and trading fee structures that allowed the HFTs to predict the other side of the trade and race ahead to the next exchange to be waiting with the goods on the other side.
No Lewis book is complete without a hero and the narrative centers on two, Brad Katsuyama and Ronan Ryan, who put together the team that uncovered the changes to the financial markets that had taken place and built a brand new exchange from scratch to give traders a level playing field. Brad, a genial, soft-spoken, Canadian and Ronan, from Ireland and just as genial, but far from soft-spoken, have created IEX specifically to thwart the unfair advantage enjoyed by HFTs (though they are welcome to trade on IEX). From a standing start in October of 2013, IEX has grown steadily to where it represents just slightly over 1% of trading volume on the U.S. exchanges in early 2015.
How it got there is the story of the Flash Boys.